Module 1 - OVERVIEW OF TRANSFER PRICING RULES AND THE ARM’S LENGTH PRINCIPLE

Welcome to the World Bank’s Transfer Pricing Electronic Learning Tool. This course consists of a range
of modules designed to be studied either sequentially or separately, depending on your specific needs
and requirements. This is a self-paced, stand-alone learning tool, so you will need to allow sufficient
time to go through each module and to study the supplementary reading material. You can stop or
pause the module at any time and you are free to navigate back and forth throughout each module.

This Tool is primarily intended to support officers working in a tax administration, who are responsible
for, or involved in, a transfer pricing audit of a Multinational Enterprise. Accordingly, although the Tool
will explain the principles underlying most transfer pricing rules, they will primarily focus on the
knowledge and practical skills needed by tax auditors to conduct a transfer pricing audit. However, this
course may also be useful and relevant to others seeking an understanding of transfer pricing in practice.

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This course is divided into a number of modules and each module will include a presentation and
exercises to help you assess whether you are on the right track, as you work through each module.

The quiz questions will not be graded but are designed to recap and reinforce your understanding of the
topics covered by each module.

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If you come across terms or phrases that are new to you, you can download the Terms and Phrases
document, which explains key terms used throughout the course. We are now ready to get started!

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Slide: 5

When a Multinational Enterprise (referred to as an MNE) establishes itself in a country, either through a
subsidiary or branch, it generally engages in transactions with other members of the group, such as
those illustrated in the diagram. In fact, as a result of globalisation, a significant portion of international
trade now takes place between members of a MNE group.

Because of the common ownership, management, and control relationships that exist among members
of a MNE group, the prices of these transactions are not fully subject to the market forces that would be
the case had the transactions taken place among wholly independent parties. And, as we will see,
changes in such prices will not normally affect the consolidated pre-tax profit of the MNE Group as
whole. Therefore, the MNE has some scope to determine and set the prices they charge amongst the
members of the group— known as transfer price.

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In this module, we will explain what is meant by the term transfer pricing and we will consider one of
the fundamental principles underlying transfer pricing, referred to as the arm’s length principle.

We begin with the term ‘Transfer Pricing’.

Transfer Pricing refers to the prices and other conditions in place when related parties conduct
transactions with each other. This statement requires further explanation to help you understand what
is meant by the key words.

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Slide: 7

Transfer pricing audits most frequently consider the effect on profit of the actual prices used in related-
party transactions. In some cases, however, other conditions of the transaction may need to be
considered. For example, it may be necessary to consider how the transaction would have been
structured between non-related parties under similar circumstances.

In other cases, it may be appropriate to disregard the transaction altogether, if, for example, that
transaction would not have taken place at all between non-related parties under similar circumstances.

The term ‘conditions’ refers not only to the price and other commercial terms in place, but it also refers
to whether the transaction would take place at all or how the transaction would be structured, between
non-related parties. In order to make such a determination, it will necessary to undertake a detailed
factual analysis.

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Slide: 8

The term ‘related parties’, also referred to as associated enterprises or connected parties, is defined by
countries in different ways. Almost all countries will consider companies that are members of the same
group to be related. This is often achieved by stipulating that two parties are related where one party
directly or indirectly controls the other, or both parties come under common control. In the top diagram,
if A controls B, then they will be considered to be related parties, and transactions between them fall
within the scope of transfer pricing rules. Similarly, in the bottom diagram, if C controls both A and B,
then A and B will be considered to be related parties; in addition, of course, to C and A; and C and B also
being considered as related parties.

We will consider how countries define ‘control’ in a later module.

Some tax administrations will also consider that an individual and a company can be considered related
where the former controls the latter by holding, for example 50% or greater shareholding.

The commercial relationship between different branches or offices of the same company is not a
transfer pricing issue because they are not separate legal entities and therefore cannot transact
between themselves. However, transfer pricing principles can be applied to attribute profit to a
‘permanent establishment’ of a company or another type of person.

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Slide: 9

In transfer pricing, the term ‘transaction’ is very broadly defined. It includes any commercial or financial
arrangement between parties, whether or not it is formalised by agreement or any other document.
This means that a commercial arrangement that is purely informal, and based on only verbal or even
implied conditions, can be considered a transaction for the application of transfer pricing rules. In
carrying out a tax examination, auditors can expect to encounter transactions including goods, services,
loans, rents and the transfer of intangibles or rights in relation to intangible assets. Countries define the
term ‘transaction’ in different ways and it is important that auditors are familiar with the definition used
in their country’s domestic transfer pricing rules.

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Slide: 10

Now let’s go through a simple example.

Happy Co, is a corporate taxpayer in your country, which we will refer to as Country A. Happy Co is a
member of the ‘Happy Group’ of companies, a large Multinational Enterprise with a presence in over 50
countries. Happy Co’s function is to distribute Happy branded goods to customers in Country A.

The ‘Happy Group’ includes a subsidiary in Country B, called Happy Co Legal Services, which provides
legal services to other group members, including Happy Co in Country A.

One item of the legal service is charged at $1000, which Happy Co pays as a fee to Happy Co Legal
Services. What would be the effect on the profit of your taxpayer, if the item of legal advice was charged,
at say a lower amount of $750, or at a higher amount of $1250?

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In the case, the legal advice was charged, at say the lower amount of $750. Happy Co Legal Services’
revenue in Country B will decrease by $250, and its profit and any tax paid on that profit will also be
reduced.

In contrast, in Country A, Happy Co’s expenses will decrease by $250 and its profits and any tax paid on
that profit will increase.

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Slide: 12

In the case, the legal advice was charged, at the higher amount of $1,250.

Happy Co Legal Services’ revenue in Country B will increase by $250, and its profit and any tax paid on
that profit will also increase.

In contrast, in Country A, Happy Co’s expenses will increase by $250 and its profits and any tax paid on
that profit will be reduced.

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Slide: 13

As demonstrated in the previous slides, the transfer price between two related persons affects the
amount of profit recognised in each of the two countries (in our example Country A and Country B).

As a consequence, it also affects the amount of tax payable in each country.

It is important to note that, from the global perspective of the Happy Group, variations in the price do
not affect the total amount of profit earned from the transaction between Happy Co and Happy Co Legal
Services.

This is because, on a consolidated basis, related party transactions are netted off. But it does affect
where profits are reported and subsequently where taxes are paid.

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It is not surprising, therefore, that transfer pricing is of great interest to tax administrations and, in order
to ensure that their tax base is not undermined, most countries have introduced transfer-pricing
legislation and increased the resources allocated to building the capacity of their tax administrations.

The introduction of rules to regulate transfer pricing (predominately for tax purposes only) allows tax
administrations to check that transfer pricing does not lead to a loss of tax in their respective
jurisdictions.

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The amounts involved can be very significant and transfer pricing remains an important issue for tax
administrations and taxpayers.

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The primary objective of transfer pricing rules is to provide the tax administration with the legal and
administrative tools needed to protect the country’s tax base. From a policy point of view, it is also
important that the rules do not result in double taxation, which, as we will see, can occur if there are
mismatches between country transfer pricing rules, or the way in which countries interpret and apply
their rules. For this reason, countries have established an international framework for transfer pricing,
which is based on the arm’s length principle.

The arm’s length principle requires that transactions between associated parties should be consistent
with those that would have prevailed between two independent parties in a comparable transaction
under similar circumstances. This principle has been adopted, in one way or another in nearly all
countries that have introduced transfer pricing regimes to date and the most common expression is
found in Article 9(1) of the OECD Model Tax Convention and Article 9(1) of the UN Model Double Tax
Convention which both state:

“If conditions are made or imposed between the two enterprises in their commercial or financial
relations which differ from those which would be made between independent enterprises, then any
profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of
those conditions, have not so accrued, may be included in the profits of that enterprise and taxed
accordingly.”

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Slide: 16

A detailed discussion on the meaning and application of the arm’s length principle can be found in the
OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations; in the United
Nations Practical Manual on Transfer Pricing and in the World Bank Group’s Transfer Pricing and
Developing Economies Handbook.

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The Arm’s Length Principle, as the international standard for transfer pricing, is not only incorporated
into domestic transfer pricing rules but also found in nearly all Double Tax Agreements, also referred to
as tax treaties.

Transfer pricing that does not meet the arm’s length standard is often labelled ‘transfer mispricing’,
which can arise for all sorts of reasons. Most tax authorities will have seen intentional manipulation of
transfer prices for tax reasons, but mispricing can also result if taxpayers do not properly consider the
impact of transfer pricing, perhaps because they are unaware of, or ignore, transfer pricing rules. This
may be because the countries they operate in do not have effective rules or the tax administration is not
equipped to properly implement the transfer pricing rules, or, where rules are in place, taxpayers may
have limited knowledge or understanding of the transfer pricing regime and its impact on their taxable
profits.

Other taxpayers may consider that the effort and cost involved in identifying and implementing arm’s
length transfer pricing does not justify the perceived risk of being subject to a transfer pricing audit.

In other cases, transfer pricing can be used as a means of remitting funds to shareholders in a way that
avoids the payment of withholding tax on dividends.

To protect its tax base from being eroded through transfer mispricing in all these situations, a country
needs to have in place appropriate transfer pricing legislation and must take steps to ensure that it is
effectively administered.

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Slide: 18

The illustration discussed earlier provides an example of transfer mispricing – if the fee payable for legal
services is set high, then profit will be shifted from Country A (where it is taxed at 30%) to Country B
(where it is taxed at 10%). All of these scenarios present a risk of potential tax loss and are of concern to
tax administrations.

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We will now delve deeper into the Arm’s Length Principle. The arm’s length principle requires that the
pricing and other conditions of transactions between related persons are in line with those that would
be in place if the persons had not been related. Transactions between related persons are often labelled
‘controlled transactions’. And transactions between unrelated parties are referred to as ‘uncontrolled
transactions’.

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Slide: 20

What is meant by the phrase “in line with those that would be in place if the persons had not been
related”. It is important to distinguish between the prices that taxpayers actually use in their related-
party transactions, and the pricing (and other conditions) on which taxable profit is computed.

The regulation of transfer pricing is primarily a taxation issue, which is concerned with the amount of
profit subject to tax in each jurisdiction.

We will see later that taxpayers may apply one price at the time of the actual related transaction, but
then make retrospective adjustments in their financial accounts or computation of taxable profit on the
basis of another price.

These types of adjustments may be made in order to comply with transfer pricing rules.

Similarly, tax administrations may also make adjustments to the measure of taxable profit or loss as a
result of applying their domestic transfer pricing rules.

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As we have seen, the arm’s length principle requires us to apply the pricing and other conditions we
observe in comparable ‘uncontrolled transactions’ to similar transactions between related parties,
referred to as ‘controlled transactions’.

That is, we need to look to comparable uncontrolled transactions to see what they tell us about the
pricing and other conditions that we would expect to be applied in controlled transactions, under similar
circumstances.

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This is the principle of comparability, which is another fundamental transfer pricing principle and is
applied by almost all countries which have transfer pricing rules.

Throughout this course we will refer to:

 Comparable uncontrolled transactions, which are uncontrolled transactions that are comparable to
the controlled transaction we are examining

 Comparable uncontrolled entities, which are entities that carry out uncontrolled transactions that
are similar to the controlled transactions carried out by the entity we are examining

 Comparables, which is a general term to describe the comparable transactions or comparable

entities we use in a transfer pricing analysis

 Comparable data, which is the financial data derived from comparables and used in a transfer
pricing analysis

 Internal comparable, which is a comparable transaction between an independent party and one of
the parties to the controlled transaction under examination

 External comparable, which is a comparable transaction between two independent parties neither
of which is a party to the controlled transaction under examination

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The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations defines
Comparability Analysis as a comparison of a controlled transaction with an uncontrolled transaction or
transactions. Controlled and uncontrolled transactions are comparable if none of the differences
between the transactions could materially affect the factor being examined in the methodology (e.g.

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price or margin), or if reasonably accurate adjustments can be made to eliminate the material effects of
any such differences.

All these will be considered in more depth later in the E-Learning Tool.

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When we consider whether an entity is ‘comparable’ to the entity under examination factors to be
taken into account include:

 the transaction itself

 the products subject to the transaction

 the physical functions carried out by the entity

 the assets owned or used by the entity (including intangibles)

 the risks the entity assumes

It will also be necessary to consider comparability of economic and market conditions, as well as the
business strategies of the entities.

All these will be considered in more depth later in the E-Learning Tool.

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In order to protect its tax base from being eroded through transfer mispricing, a country needs to have
in place appropriate transfer pricing legislation and must take steps to ensure that it is effectively
administered. The threat of a transfer pricing audit and a resulting transfer pricing adjustment, along
with the possible imposition of interest and penalties, can go a long way toward discouraging taxpayers
from engaging in transfer mispricing and toward promoting awareness and resulting self-compliance. A
detailed discussion on the policy objectives of transfer pricing legislation can be found on Pages 1 to 28
of the World Bank Group’s Handbook “Transfer Pricing and Developing Economies”.

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Slide: 25 -35

Here are some questions to help you test your understanding of the issues discussed in this Module.
Carefully read each question and then click the correct answer, True or False.

1. Transfer pricing is always tax avoidance.

2. Transfer pricing rules apply only to related party transactions that are deliberately mispriced.
3. Transfer pricing rules normally apply an arm’s length test whether or not tax avoidance is intended.
4. Transfer pricing is concerned with only the price of a transaction and the commercial terms of that
transaction (such as any credit period allowed)
5. The arm’s length principle can also be applied for attributing profit to a permanent establishment.
6. A transaction that is not recorded in financial accounts is outside of the scope of transfer pricing.
7. Transfer pricing rules can apply to a transaction for which there is no written agreement or contract.
8. Comparability involves comparing the conditions of a controlled transaction with those of one or
more comparable uncontrolled transaction.
9. An uncontrolled transaction is always comparable to a controlled transaction if the goods or services
involved are identical.
10. Read the text and then on a piece of paper write down the two phrases that are factually incorrect.
Once you have completed this exercise go to the next slide to check if you correctly identified the
incorrect phrases.

You have now successfully completed Module 1 of the World Bank’s Transfer Pricing Electronic Learning
Tool.

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